Credit discipline

CREDIT DISCIPLINE – THE WAY FORWARD Author: Parag Patki - Chief Executive Officer

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Foreword

The role of credit rating agencies (CRA) in assessment of credit risk and its mitigation is universally recognised. CRAs have played and continue to play a critical role in the development of debt markets. This role has led global banking regulators to advocate the use of rating systems by banks for assessing credit risk. One such regulation is the Basel Accord, which requires banks to use external credit ratings in assessing credit risk. As a result, the relationship between credit ratings by rating agencies and credit assessment by banks has deepened. Banks are now increasingly relying on external credit ratings for making lending decisions.

Credit discipline is an important factor considered while assessing the ability or intention of the borrower/issuer to honour debt obligations in a timely manner. The norms in evaluating credit discipline are stringent and require a rating agency to closely monitor the repayment track record of a borrower. This article explains the challenges of credit discipline and highlights the need to inculcate better credit discipline amongst borrowers.

Differing perceptions on credit discipline

Credit discipline broadly implies timely repayment of debt obligations. While this definition is simple, a dichotomy emerges in adoption of default definition by CRAs and banks. A bank would declare a borrower as a non-performing asset (NPA) account (often viewed as default as per the borrowers’ understanding) only after he is unable to service his interest and principal payment over a sustained period of time, whereas credit rating agencies would assign default rating to a borrower if he has missed payment even by a single rupee or a single day for long-term loans and a fixed period for short-term loans. For instance, under banking, an asset is treated as non-performing asset (equated with default) only when a scheduled payment remains overdue for a period of more than 90 days.

While each of these approaches has merits, the impact on the borrower differs. Risk management systems of banks are often geared to manage and mitigate losses arising from NPAs; hence, the early warning systems in banks are geared towards NPA reporting. Consequently, banks exert greater pressure on a borrower to repay as the account moves closer to NPA. While NPA denotes a loss sustained by the bank as a result of continuous default by borrower, a lower or a default rating by a CRA implies that a bank has taken a higher risk on its book and hence needs to set aside higher capital for contingency. This is the fundamental tenet on which the Basel accord is based. Thus, NPAs have a loss implication and defaults have a


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capital implication for banks (see table 1). Moreover, due to differences in defining defaults, it is probable that borrowers that have been assigned default category rating may not fall under NPA classification of banks.

Table 1: Key differences between NPAs recognition by banks and default recognition by CRAs

DEFAULT (CRAs) NPA (Banks) Missing payment by a single rupee or a single day in servicing a scheduled debt obligation.

Continuous default for a sustained period (continuous non-payment of dues for 90 days).

Implication for providing capital against the risk.

Ensuring loss provisions are made against a risk.

Globally recognised definitions of default, adopted by RBI.

RBI defines prudential regulations with respect to NPA recognition.

Consistently applied across global banks and debt markets.

Applied only in the Indian banking system.

Direct implications for financial systems.

Implications on financial systems through banking channels.

More forward-looking. More historical analysis based. Infographic 1: How Default and NPA are different from a systemic perspective

http://www.rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=715

The infographic above indicates that ‘default’ is an early warning signal of a stress in the account as compared to NPA. Differing definitions of default prevailing currently could delay meeting the end objective of Basel accord viz. scientific allocation of risk based capital in the banking system. RBI, in its recent papers, has also underscored the importance of early identification of default risks. Hence, it can be fairly assumed that the banking system could see, sooner than later,

1 daydelay

DEFAULT

90 daydelayNPA

Early warning systems of CRAs Early warning systems of Banks currently being used

Stretched liquidity, weakning economic scenario, increasing

debt

Early warning now being suggested by RBI for use in banks (Discussion Paper on Early Recognition of Financial Distress - Link)

30-60 day

delay

Higher systemic risk Higher banking risk


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policy level changes towards instilling early warning systems in recognising stress for risk based allocation of capital.

Need for borrowers and lenders to acknowledge default in stringent terms

The ‘one day one rupee’ default criterion is in line with Basel regulations, which derive credit risk weights and probability of default from globally accepted practices (see box 1 for the risk weights suggested by Basel II). These practices have been consistently applied in debt markets across all countries. The criteria are stringent, universally accepted and consistent. Default definitions across markets follow the ‘single rupee; single day norm’, which means that a borrower will be classified as a defaulter even if he misses a term loan repayment by a single rupee or a single day. Over time, the definitions of default have evolved to become stringent because of the need to identify early warning signals of financial stress. This identification gives time to the policy makers to enact proactive regulations to prevent stress and thus protect the financial system (see box 1 for default definition prescribed by RBI). The relevance of early warning signals has only increased after the financial crisis of 2008 given the integrated nature of the global financial system. The crisis has brought forth the need for relooking at regulatory oversight in the financial system (including rating agencies) and a closer scrutiny of lead indicators of stress.

Credit rating by CRAs is a 360-degree evaluation of the borrower’s credit profile. These ratings factor in industry risk, business risk, financial strength and management capabilities of the borrower. Thus, credit rating is not only an opinion on default but also an indication of the borrower’s overall creditworthiness. A rating not only fulfills a regulatory requirement but also gives the banker an independent opinion on the borrower’s credit profile. Consequently, banks attach importance to credit ratings while extending credit. Borrowers thus need to be aware of the implications of external credit ratings for the sustainability and growth of business given the evolving regulatory landscape in an increasingly integrated financial world.

Why credit discipline is a step in the right direction for borrowers:

As financial system integration increases, the need for consistency in approach to risk (globally accepted) also increases. Hence, a move towards stringent globally accepted default definitions is a step in the right direction. Moreover, borrowers are diversifying their sources of finance and are increasingly tapping capital markets for funding needs (see chart 1)


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http://www.sebi.gov.in/sebiweb/ and SMERA research

The above chart implies that diversity in funding sources is increasing in India. Also, as increasing number of Indian entities seek international funding; it becomes prudent for borrowers to adopt international standards of credit discipline.

Availability of different funding sources is important from two perspectives viz. availability of funds and cost of funds. India is witnessing rapid growth in sources of funding, be it private equity, SME exchanges, country specific funds, multilaterals or foreign investors. This implies that supply of funds is getting broad based and credit evaluation standards are becoming stringent and globally aligned.

Thus, credit ratings play a critical role in risk assessment, and more so if the default definitions are based on global standards. The opinions by CRAs are already enabling local borrowers to access funding from diverse sources. This is facilitated by publicly available independent opinion, which a prospective lender can easily access from the CRA’s website.

Accordingly, whether it is from a regulatory or a funding diversity perspective, credit discipline (as enunciated by globally accepted standards) is fast becoming the norm. Consequently, companies which exhibit credit discipline often tend to have an edge as compared to others.

12.0%

13.0%

14.0%

15.0%

2010-11 2011-12 2012-13 2013-14

Chart 1: Corporate debt and CP to GDP (at current prices) India


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BOX 1: REGULATIONS WITH RESPECT TO DEFAULT AND RISK WEIGHTS Default definition as laid down by RBI vide communication no. DBOD.BP.N/5378/ 21.06.007/ 2012-13

For the facilities having a pre-defined repayment date/due date, the definition of 'one day one rupee' may be adhered to.

For revolving facilities like cash credit, CRAs may allow, as of now, grace period up to the maximum of 30 days from the date of overdrawal, beyond which an entity would be considered to be in 'default'.

After the default is cured and the loan facility is regularized, the CRAs should upgrade the rating only if the rated entity shows satisfactory track record for at least of 90 days i.e. three months from the date of default. Generally in such cases, the rating would move to non-investment grade after curing.

Proposed risk weights as per BASEL II

Rating Basel II – Probability of

default

AAA and AA 0.1

A 0.3

BBB 1.0

BB 7.5

B 20


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Business development contacts: Sanjay Kher – Vice President Corporate Ratings Sales Tel: +91-22-6714 1193 Cell: +91 98191 36541 Email: [email protected] Virendra Goyal – Vice President Sales (SME) Tel: +91-22-6714 1177 Cell: +91 99300 74009 Email: [email protected]

Analytical contacts: Ashutosh Satsangi – Vice President, Operations Tel: +91-22-6714 1107 Cell: +91 98192 93790 Email: [email protected] Umesh Nihalani – Head, Corporate Ratings, Tel: +91-22-6714 1106 Cell: +91 98336 51336 Email: [email protected]